Fiscal stabilisation

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Fiscal stabilisation

Revenue is required by central and local government
in order to pay
for its spending commitments.
The main source of revenue is taxation, and taxes can be used to
stabilise the economy in two main ways - through the automatic
stabilisers of fiscal drag and boost, and by discretionary tax policy.

Fiscal drag

If we assume that direct tax rates are progressive,
which occurs when the % of income going in taxes increases with income,
and welfare benefits are paid, then
any increase in national income will be slowed down automatically.
This process is called fiscal drag.

Fiscal drag occurs in two ways. Firstly, when
incomes rise, aggregate demand will not rise at the same rate because
the ‘better off’ pay proportionately higher taxes, and spending growth
is constrained. Secondly, the effect on the poor and unemployed is reduced
as they come off benefits, and start to pay tax. The effect is that
the increases in disposable income are moderated.

Fiscal boost

Conversely, a decrease in national income is also
moderated through fiscal boost. Fiscal boost means that as incomes fall
the impact for the better off is ‘softened’ as they pay proportionately
lower taxes, and retain more post-tax income.

Without welfare benefits, falling incomes will
create more unemployment and poverty. However, because the unemployed
and poor receive benefits, and spend more than they would have without
such benefits, the downturn in the economy is also ‘moderated’. The
chart below shows the economic cycle with and without stabilisers. When
stabilisers are in-place, the volatility of the economic cycle is
reduced.

Discretionary changes to
tax rates

In addition to automatic stabilisation, taxes can be raised or lowered to control or expand
household spending
and aggregate demand. This is referred to as discretionary fiscal policy.

Income tax can be adjusted in a number of ways, such as by changing:

The
tax free allowance – all income earners are allowed to earn an
amount of income before they start to pay tax. For example, the
personal tax free allowance in the UK for 2014 was £10,000. Therefore, to
stimulate demand, this could be increased to give households more
disposable income.

The basic tax rate - which in 2014 was 20%.
Basic rate means the rate that affects
most income earners.

The number of tax bands – for example,
before 2009 there were three
bands of: 0 - £2320 of taxable income from savings was taxed at 10%; £0 –
£34,800, taxed at 20% tax, and over £34,800 was taxed at 40%, which
was the
higher tax rate. By adding new lower or higher bands the level
of consumption and the distribution of income can be altered.

For example, in 2014 a higher rate of 45% was introduced for those earning over £150,000 of taxable
income.

These tax bands help narrow the income gap and so
help reduce inequality.

The range of income in each band – each band could be widened or
narrowed by increasing or reducing the range of income in each band.

It should be noted that changes in individual
taxes, and taxes rates, would have a short-term discretionary effect as
well as altering the long-term structure of taxes and the ability of the
economy to automatically self-correct after a
shock.

The advantages of using
taxes

Discouraging unwanted behaviour

Indirect taxes can be targeted to alter behaviour, such as
to reduce
polluting activities
by the use of polluter-pays taxes, or to reduce cigarette and alcohol
consumption by special duties on tobacco and alcohol.

Encouraging wanted behaviour

Indirect taxes can also encourage desirable
behaviour, like the consumption of more
merit goods such as
education and healthcare. In this case, tax rates can be reduced to
zero, and production and supply could be subsidised.

Supply-side incentives

The tax system can also be used to encourage work
and effort and increase the activity rate of labour. In the 1980s
American economist, Art Laffer,
considered the impact of higher taxes on incentives. Laffer proposed that at tax rates of 100% and 0%
the government receives no revenue. At 100% tax, no one would work, and
at 0% tax, no tax would be paid. However, between 0% and 100% tax rate
the government derives a tax yield, the graph for which became known as
the Laffer curve.

Laffer curve

As tax rates rise a disincentive effect begins.
There is a substitution effect as leisure becomes more attractive and
work less attractive.

However, the disincentive effect will only
work under certain circumstances. To understand this we must distinguish
the income and substitution effects. The substitution effect suggests
that, following an increase in direct taxes, substitutes to work, namely
leisure, seem more attractive and people will work less, often called
the Laffer effect. The income effect suggests that an increase in
taxes will reduce people's real income, and they will need to work harder to
achieve the same level of real income.

These two effects are contradictory. If the
income effect is greater than the substitution effect, an increase in
taxes will lead to more labour being supplied. However, if the
substitution effect is greater an increase in taxes will lead to less
labour being supplied. Laffer’s legacy is the raised awareness
that increasing taxes to pay for public spending may, through its
disincentive effect, lead to long-term
supply side problems.

Automatic stabilisation

In the short and medium term, taxation can be
used to automatically stabilise the macro-economy through fiscal drag
and boost. These processes act as a natural shock absorber to economic
shocks.

Additional measures to stimulate aggregate
demand

Discretionary changes in direct taxes can help
regulate
aggregate demand when
shocks are
severe, or when other policies are ineffective, as in the
financial crisis of 2008-2009.
As part of an emergency package, many national governments reduced
taxes, like VAT, so that they could give an extra boost to their ailing
economies.

Redistribution of income

Tax policy can also be used to help
re-distribute income, and help achieve equity. In terms of achieving
equity, indirect taxes like VAT are regressive and create an
inequitable burden, the largest burden being on the poor and low paid.
Income tax and other direct taxes can be made progressive and can help
achieve equity, but they may have a disincentive effect leading to
inefficiencies. Hence, because equity and efficiency are in conflict,
the best resolution is a ‘mix’ between direct and indirect to achieve a
balance between the needs of equity and efficiency.

The disadvantage of tax policy

Complexity

Changing tax rates, allowances and bands, is
highly complex, especially in comparison with changing interest rates.
Because of this, changes are relatively infrequent, with only small
adjustments made each year in the annual budget. Only under dramatic
circumstances, as in the financial crisis, are tax changes put into
effect.

Avoidance

Households may increase or reduce their
savings following tax changes, so the final effect of an increase or
decrease in taxes on household spending may be weak. Taxes can be
avoided in other ways, and this avoidance may contribute to the rise of
an unofficial hidden economy.

Time lags

There may be considerable time-lags between
changing taxes and changes in household spending or other behaviour.
Demand for many products is price and income elastic, so demand may not
respond quickly or by a great amount to changes in indirect and direct
taxes. An obvious example of this is taxation of fuel, where, despite taxes
representing around 75% of the retail price of petrol, demand remains
stubbornly high.